Ethics in Finance and the CFA Standards of Professional Conduct

Overview of CFA Standards of Professional Conduct

  • The CFA Curriculum 2020 Level II (Readings 1-3) serves as the primary reference for understanding ethics in finance, particularly concerning non-bank dealers and brokers for dealers.

  • The Standards are categorized into seven primary sections:

    • I. Professionalism

    • II. Integrity of Capital Markets

    • III. Duties to Clients

    • IV. Duties to Employers

    • V. Investment Analysis, Recommendations, and Actions

    • VI. Conflicts of Interest

    • VII. Responsibilities as a CFA Institute Member or Candidate

II. Integrity of Capital Markets

  • A. Material Nonpublic Information

    • Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on that information.

  • B. Market Manipulation

    • Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

III. Duties to Clients

  • A. Loyalty, Prudence, and Care

    • Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment.

    • They must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.

  • B. Fair Dealing

    • Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

  • C. Suitability

    • Advisory Relationships: When in an advisory relationship, Members and Candidates must:

      • Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action.

      • Reassess and update this information regularly.

      • Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, and constraints before acting.

      • Judge the suitability of investments in the context of the client’s total portfolio.

    • Mandate-Specific Responsibilities: When responsible for managing a portfolio to a specific mandate, strategy, or style, they must make only investment recommendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio.

  • D. Performance Presentation

    • When communicating investment performance information, Members and Candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.

  • E. Preservation of Confidentiality

    • Members and Candidates must keep information about current, former, and prospective clients confidential unless:

      1. The information concerns illegal activities on the part of the client or prospective client.

      2. Disclosure is required by law.

      3. The client or prospective client permits disclosure of the information.

IV. Duties to Employers

  • A. Loyalty

    • In matters related to employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

  • B. Additional Compensation Arrangements

    • Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved.

  • C. Responsibilities of Supervisors

    • Members and Candidates must make reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, rules, regulations, and the Code and Standards.

Case Analysis: Hong Kong Minibond

  • Investor Perspective and Testimony:

    • One complainant, identifying as illiterate, testified: "I am illiterate. I have deposited my savings in the bank year after year. When the salesman (at the bank) recommended me the Minibonds as the most suitable financial product for retirement, promising higher interest rate and low risk, I invested HK$500,000HK\$500,000, all the money I have saved from decades of manual work."

  • True Features vs. Marketed Features:

    • Marketed Feature: High return, low risk, or even risk-free. Promoted using the term ‘bond’ to build investor confidence.

    • True Feature: A 5%5\% coupon CDO (Collateralized Debt Obligation) insured with a CDS (Credit Default Swap). It carried significant risks including credit risk, market value risk, interest rate risk, exchange rate risk, and swap counterparty risk.

  • Inherent Structural Risks:

    • If the underlying company goes bankrupt, coupon payments stop.

    • The issuer of Minibonds can withhold compensation from the CDS until maturity (typically 3–6 years\text{3--6 years}).

    • The issuer can call Minibonds prematurely. For example, if the CDS insurance provider goes bankrupt, the issuer can force a "fire sale" of Minibonds. Investors only receive the recovered value from that fire sale.

  • Misconduct by Bank Staff:

    • Front-line staff proactively induced clients to convert matured fixed deposits into Minibonds by offering higher returns and free shopping coupons.

    • Failed to consider risk profiles: Specifically targeted retired, elderly, less educated, and risk-averse clients.

    • Failed to provide product information: Term sheets and prospectuses were not provided, and product features/risks were not explained.

    • Only highlighted well-known reference underlying entities and their associated credit risks, omitting the structural risks of the product itself.

Case Analysis: The LIBOR Scandal

  • Mechanism of Manipulation:

    • Submitters overstated or understated the rates to affect the final set used in the LIBOR (London Interbank Offered Rate) calculation, moving it upward or downward for gain.

  • Traders' Benefit from Manipulation (Example of Interest Rate Swap):

    • Participants:

      • Borrower 1 (Barclays): Receives 7%7\% fixed from Borrower 2; Pays Borrower 2 a floating rate (LIBOR + 1%1\%); Pays Lender 1 a fixed rate of 8%8\%.

      • Borrower 2: Pays Barclays 7%7\% fixed; Receives floating (LIBOR + 1%1\%) from Barclays; Pays Lender 2 a floating rate (LIBOR + 1%1\%).

    • Impact of LIBOR on Barclays (Net Payment):

      • Period 1 (LIBOR at 6%6\%): Net payment of −8%-8\%.

      • Period 2 (LIBOR at 5%5\%): Net payment of −7%-7\%.

      • Period 3 (LIBOR at 4%4\%): Net payment of −6%-6\%.

    • Finding: The lower the LIBOR, the less Barclays needs to pay internally, reducing its net payment burden.

  • Numerical Example of Manipulation:

    • Assume other banks submit rates (%\%): 3.86,3.86,3.86,3.86,3.865,3.865,3.865,3.865,3.865,3.87,3.87,3.87,3.87,3.87,3.8753.86, 3.86, 3.86, 3.86, 3.865, 3.865, 3.865, 3.865, 3.865, 3.87, 3.87, 3.87, 3.87, 3.87, 3.875.

    • If Barclays submits the accurate rate (3.87%3.87\%), the calculated LIBOR equals 3.8668%3.8668\%.

    • If Barclays manipulates the rate by understating it to 3.86%3.86\%, the calculated LIBOR drops to 3.8656%3.8656\%.

    • For a loan worth 1 billion USD1\text{ billion USD}, understating the rate to 3.86%3.86\% allows Barclays to pay 100,000 USD100,000\text{ USD} less per annum. To maximize this, banks could collude to understate rates together.

  • Market Scale:

    • A manipulated lower rate of 0.01%0.01\% is significant because more than 4 trillion USD4\text{ trillion USD} in interest-rate swap contracts occur every day.

    • Data shows a massive increase in interest rate derivatives turnover (including swaps, forward rate agreements, and options) on a daily average basis from 1986 to 2022.